We have been talking a lot about investing in stocks and buying something at a discount to what you think it’s worth. A common question we hear is:

“How do I really know what something is worth?”

That’s the rub isn’t it. It’s both really simple and really complicated. The simplistic answer is that the value of a business is worth the cash it is going to generate for the rest of its life, discounted back to today. Because a dollar today isn’t worth the same as a dollar in 30 years.

The complicated part is no one knows the future and therefore how do you know what kind of cash it is going to generate?

While you can’t know for sure, Warren Buffett has famously said “I don’t know what the hottest tech product is going to be in 10-20 years. What I do know, is people will still be eating Snickers.”

His point is that it’s much easier to value a business that is predictable, repetitive and not trendy.

Rather than getting into an academic discussion of discounted cash flow calculations, let us give you a decent rule of thumb you can use for your own investing.

If you can find a business in the public markets that is fairly stable and/or growing, and you can buy it for less than 10x the cash flow it generates in a given year, you will likely make money over time.

If you are buying a private business, you typically want to demand only 3-5x cash flow. This is because business is incredibly hard and small businesses are less predictable than large established brands.

Remember, the goal is to get your money back in as few years as possible! The more unpredictable the business is, the more competitive risks that exist, the lower price you should pay.

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